McDonald's: Looking a Bit Overvalued

By Rob Weigand

I’m thinking of a stock that’s beaten the S&P 500 by over 300% in the last 6 years and by 70% in the past 6 months (see charts below) . . .

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. . . and, it’s accomplished this heady feat with an average 5-year compound growth rate of 7%, an average return on capital of 12%, average operating margins of under 20%, and modest growth in free cash flow. Yes, that’s MCD I’m talking about, whose admirable run is starting to look a little tired.

I modeled MCD’s value using the following assumptions: 1.) an average 5-year growth rate of 7% tapering to 5.5% over the following 5 years, and a long-term growth rate of 5.0%; 2.) a moderate reduction in its SG&A/Sales ratio from 10.7% (historical average) to 10.0%; 3.) slightly lower marginal tax rate of 30% (historical average 32%); 4.) long-term dividend growth of 6.0%; 5.) lower Cash/Sales of 8.0% (historical average 10.0%); 6.) and a gradual decline in its PPE/Sales ratio from 92% to 86% over the next 10 years (a generous assumption). At a weighted average cost of capital of 9.5%, MCD’s 2009 intrinsic value from a discounted cash flow model comes in right around $44 a share, vs. its January 12 closing price of $60. Re-running the model with 9.0% growth for 10 straight years and bringing down the PPE/Sales ratio several additional points, the intrinsic stock price perks up — but only to $53 a share. Additionally . . .

Insiders love to sell this stock. Cumulative insider selling, data provided by Thomson/Reuters (TRI), for the past 4 years is shown below. Insiders have cashed out of their positions to the tune of over $160 million over this time frame. There’s no evidence of any insider accumulation in the past 4 years. The selling is broad-based as well; it’s not just one or two big sellers.

Short interest in MCD has eased off recently:

But short selling has been off all year; considering this year’s light market volume, MCD’s Days to Cover Ratio is higher than it’s been since 2004, suggesting this overvaluation story may be gaining some traction:

MCD also sells at a premium Price/Sales ratio vs. competitors such as Yum Brands (YUM):

Although their Price/Earnings ratios are comparable:

One major caveat: This is not a short-sale recommendation. Given investors’ overall fearfulness these days, I have no compelling thesis suggesting MCD should fall sharply in value in the next few months. This is the type of stock investors have been crowding into, which is probably how it’s become modestly overvalued. For current shareholders, however, MCD seems like a prime candidate for writing covered calls. June 2009 calls with a strike price of $65 closed at an ask price of $3.20 today. Collecting that premium yields another 5% in the next 6 months — not bad in this market — plus another 8.3% return if your shares are called.

Comments

[Stock Trade...:]

Good analysis of MCD. If the general economy continues to decline from here, that will likely add additional downward pressure to MCD from here as well. From looking at the charts, it appears that this is a real possibility. MCD appears to have dropped into a new, lower channel last October and is now near the top (overbought area) of that channel. I agree about the long term for existing shareholders, it does appear like a good opportunity to be selling covered calls at this time. Nice job.

Jan 13 08:38 AM

[User 68127:]

Agree. MCD is at a steep premium to the market without an impressive long term growth rate--although ANY growth at all is impressive at the moment!

So you have little return potential and a lot of risk should anything go wrong. In any event, at some point, people driving less and having less disposable income has got to negatively impact sales...

Jan 13 11:54 AM

[mcdinvester:]

Disagree- I see MCD with a long term growth rate. Sure at the present time, investers are jumping on MCD stock and should. McDonald's is resession resistant. why? because of keeping low prices, convenience of location and close by on your way. Driving less doesn't effect MCD. They are on the way. Disposable income doesn't effect because people eating out will now choose a lower price restuarant. People don't seem to want to cook. They have a habit of eating out. No - Everybody is not going to MCD but more will go then before because of habit.( increase sales ). MCD new coffee products will also help. MCD is on a roll. People who can't afford to eat out now will come out after the economy starts climbing and MCD will be on another roll. Over valued I don't think so. MCD adverage share price has been $57.00-$58.00 though the volatile market. MCD is one of two companies that has been on the plus side. The other one being Walmart. I see a 8% long term increase for McDonald's (same store sales) and McDonald's is building about 240 stores overseas. That's all I have to say for now. I'll return later. McDonald's is a definitely buy and hold.

Jan 25 08:51 PM